National Software Strategy for Scotland

1.1 Software and services is the largest knowledge based industry with global sales of products and services of around £200 billion (1996). Global growth is strong and this is set to continue for the foreseeable future and in our opinion represents a major and significant development opportunity.

1.2 The market for packaged software represents slightly more than 50 per cent of the total industry output. Packaged software is more easily distributed internationally compared to much custom software development and services, which are often focused towards more domestic or local markets. The industry is truly global, with the US as the largest market and the largest supplier of software.

2.1 For the purposes of formulating a development strategy, we believe it is essential to include the principal sources of activity and the main economic actors in software.

2.2 Therefore we define software in Scotland as including activity undertaken by firms whose sole business is in software, both indigenous and foreign owned firms. In addition, we include those significant software development activities of a selection of major IT users. This is an important component of the software community as it adds to the potential seedbed for spin-out activities, advanced demand and is a significant contributor in the development of software skills.

2.3 We estimate employment in Scottish software as defined above is about 19,600 people. There are 7,400 people employed in 220 indigenous software firms in Scotland, and a further 250 sole traders and 3,000 individual contractors. Adding the software divisions and subsidiaries of non Scottish software firms and selected software development activities of major users, adds another 8,950 employees. Industry turnover, we estimate at about £1.4 billion, and to be growing at around 15% p.a.

2.4 The Scottish software industry is characterised by a large number of small and micro businesses. There is evidence of a growing number of firms in the 10-50 employee range, including some important "star" Scottish performers. The Scottish industry lacks a strong export orientation and is focused on Scottish and UK demand. There is no major internationally recognised software company developing software in Scotland, and foreign direct investment in software has been low. Overall there are insufficient international linkages

2.5 Survival rates of start-up firms in Scotland do not appear to differ from the rest of the UK. However, we believe Scotland is not realising its potential in the number of new start-ups created. An important part of the reason is lack of access to advanced and specialist advice and resources required by new software firms.

2.6 Most critically is the bias within Scotland’s activity towards local for local service provision, rather than the local development of software products for international markets.

3.1 We believe there is a critical mismatch therefore between global trends and the current state of software in Scotland. Specifically evidenced in:

• the bias towards services not products;
• the lack of international linkages and business;
• the lack of a significant major international recognised player in Scotland.

3.2 This is particularly important with regard to the bias towards services, and lack of international business and linkages. Also the "star" firms in Scotland are spread across a number of different product markets, with no natural key emerging focus and little linkage to highest growth market segments.

3.3 Additionally, mid to long term (5 years and beyond) we see that commoditisation within services, together with the emergence and dominance of large international service providers meeting the needs of national, international and global customers will deny some of the service market currently accessible to Scottish firms. Job prospects are threatened by these key weaknesses.

3.4 However on the basis of discussions with the industry we see no immediate threat to continued growth of software in Scotland for at least the next two or three years, given Year 2000 and EMU requirements.

4.1 We believe there is a need for a realignment of Scottish industry to better exploit global opportunities and realise the full potential within Scotland. The strategy we propose is a Scottish solution to a Scottish situation which builds primarily on evidence from Scottish industry and partners, and experience of other more successful comparator regions. In particular the proposed strategy addresses the need:

• to build greater scale of activity;
• to achieve more rapid structural adjustments;
• and to better access key specialised resources.

If not addressed, we re-emphasise that growth and employment will be constrained.

4.2 In developing the strategy with partners and stakeholders we considered a range of strategic options. We concluded that certain of these options are either unrealistic or fail to realise the full potential of Scotland. Our key strategic thrusts are;

• increased productisation;
• increased internationalisation;
• development of innovation;
• and initiatives around Scottish infrastructure.

4.3 Productisation will increase the geographic reach of Scottish firms, increase value added and shift the industry away from a commoditised future in services. Increased internationalisation is essential to more fully engage with global opportunities, maximise business potential and better align with industry trends. Innovation is a key characteristic within software, and is concerned with both increasing the numbers of start-ups, their survival and indeed shifting the profile of existing firms. Our proposed initiatives on infrastructure focus on entrepreneurship and new firm formation, including access to specialised skills and expertise, and their development.

5.1 If the strategy and recommendations are successfully and vigorously implemented we foresee a re-alignment of the industry in Scotland from:

• one overly focused on local service provision to local customers, towards
• more locally developed products for national and international markets, moving to
• products developed either independently or in association with other international players for international and global products
• whereby a critical mass is achieved and Scotland’s innovative capacities are significantly enhanced.

5.2 We believe the benefits of this future state are that the industry can double in size to over 50,000 software professionals (10 years). Importantly, the industry becomes locally self sustaining, whilst internationally linked.

6.1 Given the sustained market growth, low barriers to entry for new firms, and demonstrable evidence of success by local Scottish firms, we see the future vision as achievable. This will require excellent executional capability within each and all of the initiatives and programmes as a necessary condition for successful industry re-alignment.

6.2 We see no disadvantage or impediment from geographic peripherality as evidenced by the comparative work we undertook in other regions around the world. Indeed these other regions also demonstrated that step change can occur in a relatively short time frame. This distinguishes software from many other sectors.

6.3 Scotland has several of the key factors that provide the building blocks for success - notably world class universities and research base. It also has some of the institutional levers and infrastructure necessary to facilitate the required change, together with Scottish ownership and control in much of the industry.

7 Implementation

7.1 Developing the strategy with stakeholders and partners in Scotland has produced a number of proposed key initiatives and programmes for further discussion. These represent an integrated approach for the achievement of our proposed future state vision.

7.2 Importantly, a process needs to be designed and agreed which engages the partners and stakeholders in the software community to take these initiatives forward.

Software is the largest knowledge-based industry with global sales of software products and services estimated at around £200 billion and expected to grow overall by about 10% per year for the next three years. Whilst experiencing significant growth, Scotland’s software industry is an average regional player within Europe’s developed economy. The nation’s industry has significant local provision for local consumption and a handful of "star" firms.

Any strategy for Scotland must be cognisant of the likely continued domination of the global software industry by United States vendors. It is already the case that successful software regions outside the US rely very heavily on strong technical and commercial links with US firms. This will become more intensified in the future with regions faced with the choice of full engagement in the world-level game or consignment to the "also-rans" in software.

This strategy sets out the way forward for Scotland to engage more with the international software industry, build critical mass, and develop a more innovative, dynamic self-sustaining software community. In preparing it, Ernst & Young has undertaken an analysis of the current state of Scotland’s industry and of key global industry trends. We have consulted with a wide range of Scottish software firms, a sample of software customers in Scotland, and important support organisations. We have also analysed other regions that show some similarities with the Scottish situation and we have brought together key Scottish players to generate ideas for future development.

As a result, we have a dataset that allows clear identification of structural weaknesses in the Scottish industry and barriers to its future development in terms of size, structure and resources. These allow us to highlight major strategic themes within which we set out specific programmes.

Later in this document, we describe the broad strategic options available, and discuss their relative merits. However, whilst the "do nothing approach" is amongst these options, it would be an unattractive choice because trends within the industry - such as the consolidation of service providers - may constrain further growth in the medium term. This would be a considerable setback because software offers significant economic opportunities for Scotland.

In addition software is a key knowledge industry that helps to underpin the competitiveness of Scotland’s major industries. Indeed, much of the nation’s professional capability in software resides in its major firms in, for example, financial services and information technology. Crucially, the industry creates high quality, high value jobs - presently at the rate of about 5 jobs per day in software companies - that have employment multiplier effects into the rest of the economy.

The software development activities within electronics companies in Scotland are mostly concerned with product or system design and development. The scale of this activity compared to the number of hardware manufacturing/assembly sites is relatively small. Growing this activity would add to the critical mass of software in Scotland, and help to add an important additional seedbed for innovation. However, the location of these activities is a strategic issue within electronics companies rather than a focus for a national software strategy. The software community in Scotland can contribute in this process through demonstrating skills and competencies within the region.

In looking to a more proactive way forward, the objective set for Ernst & Young was to define a strategy to create and enable an economically strong software industry in Scotland. Our terms of reference determined that such an industry should be coherent and compare favourably in measurable respects to other comparable regions. It would operate with world class practices and be a high value-added centre.

To achieve this vision for Scottish software will require a marked change to the current industry structure. Scotland has no major indigenous software players that would provide a central focus to the mass of smaller firms, or the critical mass necessary for seedbeds of innovation and business formation, to attract skills and retain the computer sciences graduates trained in Scotland each year many of whom borne Scotland and apply their skills elsewhere.

There are two mechanisms for overcoming this structural gap in the short to mid term; grow existing, medium-sized firms to create indigenous larger firms, and/or inward investment. We will show that the key to achieving both these mid-term aims is "internationalisation"; that is, that Scottish firms engage more fully in world-level markets and supply chains. This will be underpinned by more substantial "productisation" than is currently the case in Scotland. Longer term, Scotland should build the critical mass and local innovative culture that underpins successful, globally important software regions. This is a challenging and exciting vision.

We begin in the next section, by addressing the potential for software in Scotland and examining its current structure and future markets. We review the broad strategic options in section 3 and provide a programme of initiatives for the way forward in section 4.

The strategy described is based on a significant amount of research and analysis and we provide additional insight to this in the Appendices.

• Appendix A reviews the industry scope of the strategy.
• Appendix B describes our approach.

Then we provide a series of summaries of the individual research modules of the project. These summaries are provided as follows:

• Appendix C - Current State Analysis;
• Appendix D - Global Trends Analysis
• Appendix E - Key Development Issues;
• Appendix F - Strategy Workshop;
• Appendix G - Exemplars.

Defining Software - The Challenge

For those readers not fully familiar with the software industry, it is important to note that software markets can be usefully segmented into areas with distinctly differing prospects and dynamics. The principal division is between software products (or packaged software) on one hand and software services on the other. Software products include, for example, Application Solutions - the software used by the general public and within industry - and Application Developments tools - the software needed to write software. Software Services include activities such as training, customer software development, software maintenance and facilities management. A useful market characterisation is to look at the lifecycle of software services in terms of planning, implementing, maintaining and operating. The market forecasters International Data Corporation (IDC) have set the de-facto standard for the segmentation of software markets and we reproduce this segmentation in Appendix A.

As a relatively new industry, software requires analysis in terms of skills whether they fall inside or outside any formal industry. Our exemplar studies have shown that other leading and emerging software regions have recognised that skills dominate the development of the software industry rather than the technology.

Accordingly a metric for assessing the economic development approach in software is employment. In examining development paths for the software industry, we must take into account:

• the important role played by firms in developing software skills but whose principal business is not in software;
• the vital role of large firms as seedbeds for entrepreneurship in software even when those firms are not dedicated software firms.

For Scotland, these factors are borne out of the high instances of embryonic firms that emerged from large, non-software firms. They are supported by our consultations with the principals of Scottish software firms who emphasised the role played by large, non-software firms in providing skilled professionals in the most important technologies.

Therefore, for the purposes of our analysis we included software developed within firms whose business is not principally software as well as independent software firms and software consultants (we describe the scope in Appendix A). We describe this potential in the next section. We use the following terminology to distinguish this characterisation:

• software industry: independent software firms and consultants whose principal business is software;
• software community: adding to the software industry:
• significant software development activity undertaken within firms whose principal business is not software; including
• software development activities undertaken within electronics companies in Scotland (embedded software).

In this section, we describe the Scottish software community as it stands today in terms of its size, structure, growth, and performance. We discuss the supply side - covering the capability and structure of Scottish industry and community - and the demand side - the growth of global software markets. We show that, whilst Scotland has significant potential in software, it also has weaknesses in terms of the industry structure and at the micro-level in terms of company practices. It will need to overcome these weaknesses if it is to fully exploit the substantial market potential.

In amongst the Scottish software industry, there are undoubtedly some bright stars. They demonstrate the opportunities that exist in software, and Scotland’s intrinsic ability to respond.

The stars include:

• ASCADA Limited: provides new generation Distribution Network systems for Management Systems in the utilities sector - about 28 employees;
• DMA: world class consumer games developers with almost all output exported to the US - about 27 employees.
• Graham Technology Limited: top level benchmarkeable product in call centre platforms market - about 80 employees.
• Kingston-SCL Ltd: took off with an excellent product in mobile communications billing systems; now has about 370 employees;
• Newell and Budge Limited: Specialist services in IT consultancy, training and applications, bespoke systems building and support services - about 150 employees.
• Quadstone Ltd: high tech/high risk technology in the area of decision support; emerged from the Edinburgh parallel computing centre - about 60 employees.
• Real-Time Engineering Ltd: advanced manufacturing for the oil & gas, petrochemical, aviation and power generation industries - about 85 employees.
• Scottish Computer Services Limited: technology based solution provider for Financial Services industry - about 23 employees.
• Valstar Systems Ltd: provides software consulting and products for Business Performance Improvement and Manufacturing Systems - about 60 employees;
• Weir Systems Limited: main product is state of the art using Powerhouse 4GL and structured using relation theory - about 200 employees.

These firms - and several more like them - are experiencing either rapid or steady growth. They have all exploited unique product and service ideas in response to identifying highly specific niche market opportunities. Their existence demonstrates that Scotland has the potential to develop leading firms.

A number of the firms described above are part of a "new breed" with (typically) 10 to 50 employees. Our database of Scottish Software enterprises shows that this group is distinct from the sole traders and small firms, on one hand, and the large firms and those with significant in-house software development activities that are, themselves, not dedicated software firms. Evidence from a previous study of the Scottish industry undertaken in 1994, and our tracking of individual company cases, shows that most of the new breed firms have developed in the last 3 years. We conclude, therefore, that the industry is moving away from being dominated by very small firms and in-house capability and beginning to form an important mid-size grouping within its structure.

We examined the existence and importance of supply chains and vertical industry clusters in Scotland. Some spatial proximity of software companies in oil and gas, financial services and utilities exists. These offer embryonic prospects of developing some characteristics of more mature clusters. However, it should be noted that supply chains are generally short in software.

In particular, Scotland has major customers, with local decision making autonomy that offer existing and potential routes to international markets in:

• Financial Services;
• Oil and Gas;
• Utilities;
• Information and Communications Technology.

The potential within these relationships should be leveraged as part of the national software strategy, focusing on developing higher level, advanced products within customer/supplier linkages.

The distribution of firms sizes within the software community is far from homogenous. Kingston SCL is Scotland’s largest independent software developer with 370 employees and is "out on its own" in terms of size. The chart below shows the size distribution of Scottish software enterprises by number of employees. Most of the firms with over 100 software employees are not principally software companies but are those with significant in-house software capability or autonomous software divisions; for example, hardware electronics firms.

Why should the lack of large software firms in Scotland be of particular concern in its future development? Evidence from successful industry groupings elsewhere suggests that the existence of large software firms is vital. Whilst smaller firms provide the dynamism required for a competitive software industry, larger firms act as gateways to international markets, attract and retain skills, and act as "ambassadors" for local capabilities. Crucially, large firms are proven as the most important seedbeds for software business formation and provide the training grounds for skills in advanced technologies.

As such, Scotland’s lack of large software development firms is a serious barrier to further development. Addressing this weakness is central to the strategy. In addition, whilst the Scottish industry has grown rapidly in the last few years - and is set to continue to grow - the lack of major scale players represents a structural imbalance.

Having reviewed Scotland’s capability to deliver and prior to analysing the strategic options, we now turn to the demand expressed by the market.

As we show in the next section, most of Scotland’s independent software production and service provision is for local consumption. Therefore, in the short run, Scottish fortunes in software will be governed by the local market. Detailed data on the Scottish market - disaggregated from the UK case - is not readily available. However, our interview programme showed that most firms regard the UK - rather than Scotland - as their backyard.

The UK markets for both software product and services are likely to grow substantially over the next three years. For services, the UK market will follow overall European trend and grow between 9% and 13% for most sub-sectors. The UK software products market is also expected to grow substantially at about 8 to 10% cagr to the year 2000.

In 1996, software and services accounted for about 27% of the world market in information and communications technologies (ICT) at about £200 billion. The growth of global ICT market in 1997 is expected to be about 8%. The United States represents 42% of the world market for software and services (1996).

Western Europe accounts for about 30% of the world software market (based on 1996 figures) and the UK represents about 15% of the European figure.

Growth in the global software market is likely to be substantial to the year 2000. This is driven by:

• the increase in processing speed and data storage capacity enabling, inter alia, higher levels of abstraction and subsequent demands on software;
• increasingly short product lifecycles for PCs. According to Gartner Group PC product lifecycles have moved from 18 to 24 months to 6 months or less. This is driving down software product lifecycles;
• the growth of Internet usage - currently doubling in size every 53 days;
• increased user-demand for system inter-operability and standards driving the introduction of open-systems and pseudo-open standards;
• the organisations that use business software are becoming increasingly disaggregated and whilst simultaneously becoming more customer focused adopting and requiring more sophisticated software;
• addressing the "Year 2000" issue and system changes to cope with the introduction of European Monetary Union (EMU).

These trends are likely to continue - further driving demand for software.

However, Year 2000 and EMU present major strategic risk to the achievement of strategic change. They will divert significant resources into resolving issues which are short/mid term and provide little scope for long term leverage. Similarly, users IT budgets and management will be stretched and there will be less scope for developing new applications and relationships.

Given the substantial market growth and Scotland’s ability to supply, we now review the supply structure. In fact, US companies hold the major share of almost all software markets. On current best judgement, we anticipate little change in this position for the foreseeable future.

In Europe, US vendors supply over 60% of the packaged software market. In the UK, 48% of the market for services held by the top 15 vendors (which is most of the market) is held by US vendors.

However, despite the dominance of the top vendors (mainly US), independent software vendors are gaining market share at the expense of systems vendors.

The overwhelming message is that US vendors dominate the supply of both software products and services. The exemplar studies showed that some other regions and countries have explicitly recognised this dominance. They look for engagement and integration with the US industry seeing the US suppliers as the main routes to global markets.

By nature, the software sector is favourable to new entrants that may be able to respond to market trends very quickly. Software firms have inherently low capital and start-up costs. Engaging in the international scene is an essential requirement of developing Scottish firms but is not the only issue. Our consultations with the industry revealed three additional issues - representing both constraints and opportunities - as follows:

Scottish software firms - like European firms in general - have not been able to emulate the US venture capital phenomenon. Our consultations with Scottish software firms showed that this is not due to limited venture capital availability but, rather, is constrained by:

• limited business angel activity and other seed capital (not withstanding SDF’s heroic efforts);
• a shortage of non-executive officer skills;
• low growth aspirations of individual firms; and
• a cultural reluctance to forego or dilute equity that does not benchmark favourably with US (or Israeli) practice.

As a result, presentations and communications with venture capitalists are low in effectiveness and low growth firms encounter difficulties with venture capital and lack funding.

"Shrink wrapped" applications are the highest growth and profitability segments within software. However, firms looking to productise face barriers in the form of costs and additional and different skills requirements. This is exacerbated by the financial constraints outlined above.

Furthermore, Scotland lacks a wide range of firms that are willing to act as software product test sites. This further inhibits product development as potential suppliers face going outside the country to properly test potential products - at added cost.

People and skills are the fundamental success factors in software. The key combinations are:

• sourcing sufficient supply or access to trained software engineers with high level skills;
• retaining high level skills;
• managing software development and implementation work whereby appropriate skills are used for appropriate tasks and individuals are not overskilled in their roles;
• access to experienced non-executive directors with knowledge of wider business management, deal making, funding and finance, and managing growth and innovation;
• combining or sourcing both technical skills with commercial skills especially in small and mid sized firms <100 employees.

Scotland produces a significant number of skilled software graduates, but it is generally recognised that there is a low level of retention of the skills in Scotland. A significant contributory factor in this process is the lack of major national, international or global software firms in Scotland.

Many small/mid sized firms report difficulties in accessing commercial skills appropriate to software. This is characteristic of a region which lacks scale of activity, the presence of larger firms and developed international linkages. Our studies of other exemplar regions demonstrated similar development issues in their early growth requiring solutions from out-of-region. As scale and recognition of the industry grows, then local skills retention increases and international and financial linkages provide access to a wider skills pool.

Scotland is likely to continue its present growth in software over the next 2/3 years based on our assessment of demand, growth and Scotland’s capabilities, including its handful of star firms and an emerging new breed of mid-size, indigenous suppliers. The UK and European markets - in line with global trends - are set to continue to grow offering a range of opportunities

However, Scotland has a weakness in its software industry caused by the absence of large scale major players and over-dependence on local service provision and access to advanced and specialist resources - notably skills finance and networks. To overcome this, the strategy must enable growth through more significant engagement in the international scene - especially with US firms. However, they face significant constraints:

• ineffectiveness in exploiting venture capital;
• high barriers to product development;
• potential pressure on skills.

In the next section we review Scotland’s strategic options. In doing so, we are mindful of ways to overcome the constraints outlined above.

In this section we set out the broad strategic options available to Scotland in developing its software industry. For each option, we discuss the relative merits, the broad feasibility, the resource costs and the economic impact.

The five broad options are:

• "do nothing": continue to implement existing initiatives but put no new ones in place;
• become low cost: compete on the basis of low cost product development and services;
• aim for innovation leadership: develop Scotland as a centre of excellence for new exploitation of new product ideas with a self-sustaining, entrepreneurial software culture;
• market and technology focus: choose the most favourable market and technology candidates and focus support on them;
• internationalisation and productisation: concentrate on engaging in the international scene and support product development.

With the substantial growth in Scottish software witnessed in the last 5 years set to continue over the next 2 or 3 years, our review of the options must address the possibility of implementing no proactive strategy for software in Scotland and providing no additional support to the sector. Indeed, Scotland has several initiatives in place to support the industry; both directly or indirectly.

The Scottish Software Federation provides wide-ranging support to the industry through various programmes including an industry directory, member services, and promotion of specific issues such as Year 2000 awareness. Scottish Enterprise has created a set of SOFTNET Centres - acclaimed software company incubators based at corporate sites. Scottish Enterprise also supports an industry journal and a comprehensive array of indirect support mechanisms in areas such as business formation, export, and foreign direct investment.

However, Scotland needs a more proactive, deeper software-specific strategy to respond to important future changes in the industry. Our prediction that the sector will continue to grow in the short term is based on the ‘local for local’ nature of the indigenous industry. Indeed, the UK market is set to expand by about 10% a year for the next three years and national firms should be able to exploit this local market growth.

However, as we approach the medium term, two important trends will begin to have a significant effect on the national industry:

• commoditisation of many services and associated lower value;
• polarisation of service providers, with a few, but growing number of international and global providers servicing national, international and global companies; whereby
• accessible local demand for local service companies decreases;
• continued substitution of products for services.

• high growth rates and higher value and returns;
• increased market reach (distribution, support and business linkages).

A "Do Nothing" approach will result in under-achievement of potential and represent a missed strategic opportunity for Scotland. Scotland needs to reposition towards products.

The global services industry is consolidating due to intense competition. As a result, service providers are increasingly looking to leverage low-margin service offerings across wider markets. In addition, more and more service clients are looking for a fully comprehensive service. Consequently, local service firms are becoming targets for acquisition.

This trend is particularly important for the Scottish industry in which only about 15% of firms are "products-only" outfits. For Scottish service firms, the options will, be to either confine business to highly niche markets-constraining growth - or play a support/delivery role for larger - mostly foreign owned - vendors. This second option will become even less profitable as standard solutions become more available and transportable, and require less value-added implementation.

The world market for packaged software is expanding rapidly, at the expense of the market for custom software solutions. The growth rate of the world market for packaged software is expected to outperform the market for ICT by around 2% up to the year 2000. The comparative performances of custom and packaged software in Europe are shown in the chart above. The absolute size of the European market for packaged software, at $35 billion in 1996, is almost three times as large as that of custom software ($ 11 billion).

There is a substantial difference in the profitability expectations of service firms and product firms. Ernst & Young would expect product software firms to deliver profitability of 20% to 35%; "if they got it right". However, we would expect bespoke software and service firms to make profits of less than 10% on sales; usually 5% to 6%. The same is true for smaller product software firms - say with turnover of £2 million - because of the higher relative importance of product development.

Therefore, if the Scottish software industry is to maintain its growth, it must maintain and increase its presence in software products especially packaged software. This is borne out by the fact that most of Scotland’s star firms with high growth are product firms (see Section 2). However, software product firms have a strong tendency to hedge risk by introducing services to their market offerings and then proliferate the level of these service lines. Our interviews with Scottish Software firms showed that product development costs are the main cause of this hesitance. Scottish firms also face a lack of local test sites for their products. We describe the barriers to productisation in more detail later in this report.

With high competitive pressure in software services and the likelihood of a lower relative, Scottish presence in software products - the higher profitability/growth side of the sector, Scottish software will be under significant pressure as it approaches the medium term. The net impact is likely to be a downgrading of the sector to lower value business.

However, the opportunity cost to Scotland of not taking strategic action would be:

• erosion of margins and added value through continued service bias and consolidation;
• a parochial provision increasingly less relevant in a global industry;
• lost opportunity to create significant levels of high value-added professionals in the Scottish economy.

Therefore, we conclude that the "do nothing" option is not attractive.

The high transportability of software products and the evolution of engineering quality practices in the production of software has led to the potential for lowest cost producer advantages in some localities. The instance of increasing software production in India and Pakistan is a well known case in point. In addition, some very remote localities are able to offer a very high quality of life - normally associated with holiday resorts - to software engineers (for example, the Electronic Commerce software projects in the Balearic Islands).

For its own part, Scotland has both labour-cost and quality of life advantages over selected software regions in the UK and the rest of Europe. However, these cost advantages - though significant - are much less than those offered by countries with less-developed economies. Major international companies that have satellite offices in India and Pakistan are able to draw staff from a pool of 96,000 new computer graduates each year. New recruits earn an average monthly salary of £145.

As such, whilst Scotland has labour cost and quality of life advantages within a Western European context, the increasingly global nature of software means that establishing itself as a low cost producer is not an attractive or indeed feasible strategy.

As we discuss later in this document, Scottish software lacks clear identity and numbers of new start-up firms; our exemplar studies showed that it is not known for any specific strengths or advantages.

Innovation is a feature of stronger, deeper more internationalised software regions throughout the world. Evidence from the exemplar work shows that innovation is an embedded and important characteristic of more mature software clusters such as those in Israel, Colorado and Silicon Valley.

The necessary pre-conditions appear to be:

• a strong higher education system producing high level skilled software graduates;
• a critical mass of software development activity (including independent software firms and embedded software development/hardware firms).

Evidence from Israel and Colorado suggests that given local will and entrepreneurship, suitable capital can be attracted to the region, which can also in itself provide linkages to wider marketing networks and commercial skills.

Scotland has a significant output of computer science graduates and universities with strong international reputations. However, again it lacks any critical mass or presence of international software firms to retain, train and apply their skills in significant numbers. More start-ups in software arise from large firms than directly from universities, and this is not unique to Scotland.

Israel provided evidence of how two local start-up firms ( Magic and Checkpoint) had a major impact on attitudes to innovation in software. However, the Israeli economy was locally bounded (unlike the South East of England for Scotland) and had no easy exit route for graduates.

Recent work by the Royal Society of Edinburgh and Scottish Enterprise on commercialising Scotland’s Science and Technology puts forward a strategy to increase the contribution Scotland’s science base makes to economic wealth in Scotland. A number of priorities are identified aimed at:

• existing companies;
• spin-outs;
• corporate base;
• finance;
• academic achievement;
• infrastructure.

These provide an added framework to help develop the innovation potential. Overall we believe support and encouragement to innovation and commercialisation should continue, including within the software community. However, self generating, sustainable software innovation of a significant scale will largely depend on developing the scale and linkages of the software community in Scotland. As such it should be both a continuing theme and a mid to longer term aspiration.

One option available to Scotland is to concentrate on the technologies and markets in which it performs best. This strategy would involve identifying Scottish strengths and matching them with technologies and markets that demonstrate the highest potential for growth.

For example, Internet usage has grown at an astonishing rate; it doubles in size about every 53 days. This has led to a significant number of start-up firms - mainly in the US - offering Internet services or developing Internet software; spurred by the JAVA programming language. Clearly, there are significant opportunities for Scottish firms.

Figure 3.5: Global Market for Internet Development Tools

However, as a central pillar to the strategy, technology and market focus offers significant challenges to Scotland in terms of both identifying strengths and aligning them with growth markets. This is because the Scottish software sector demonstrates little coherence. Indeed, no two of Scotland’s star software firm’s operate in the same technology and vertical market segments. Scotland has a number of games software firms but these are relatively small and do not represent a coherent entity or critical mass.

"Reverse engineering" the markets by looking at key market growth areas and examining what Scotland has to offer does not lead to any strong direction. IDC predictions of the most promising packaged software segments show that, within software products, consumer applications are likely to enjoy very high growth rising from a UK market size of $170 million in 1997 to over $250 million in the Year 2000.

However, analysis of the current state of Scottish industry shows that - of the ten product sub-sectors (within the IDC segmentation system) - consumer applications is the seventh most frequent with only 8 citations out of 248.

In addition, four of the most promising growth segments are in applications development tools; all being connected to the recent take up of object technology (eg Object CASE, Object DBMS). Again, there are very few Scottish firms producing such development tools. Systems utilities - a sub-segment where Scotland has significant capability - is expected to decline over the next three years.

In the light of the apparent mismatch between Scotland’s strongest areas and market-segments with the strongest growth, using prescriptive market and technology focus as the lynch-pin of the strategy would not be successful.

In any case, we would have strong reservations about such a strategy in practice because the nature of software mitigates against such a prescriptive approach. Whilst growth predictions concerning certain market segments are fairly reliable, future markets will be characterised by unpredictable benefits. Business formation of software firms tends to be ad hoc; relying on the particular aspirations (and often frustrations) of technocrats who identify a specific market opportunity.

However, there are important lessons of success in the experiences of some of the star companies referred to earlier. (Scotland’s Potential: Scottish Supply). These companies have succeeded in niche (often product) markets. In many of these firms, their ultimate success did not occur within the market originally selected for focus. Flexibility, nimbleness and a willingness to change early characterised several of these businesses. In many respects this contravenes much conventional business advice regarding consistency of purpose and maintaining focus.

The exemplars demonstrate the significant role that networks - particularly those of experienced Venture Capitalists - play in accessing:

• wider business skills and advice;
• business partners (often channels/distributors).

Access to advice may be a crucial factor in helping to shape and reshape these early strategies into eventually focused winners.

Established software firms - looking to grow - are usually aware of the specific constraints facing them in market development. They are unlikely to respond to pressure to move into unfamiliar markets. A much more effective approach would be to enable firms to overcome the barriers they face in becoming established and growing rapidly. We address such an approach below.

This strategic option would look to strengthen Scottish software firms in the short to medium term that are looking to establish a more international presence and to productise their offerings. As an option, it addresses Scottish software’s structural weakness in having no indigenous firms with over 500 employees.

This strategy would encourage and induce:

• more full engagement of Scottish software players in the international scene;
• much more rapid entry into the international scene for embryonic firms than is currently the case;
• substantially advantageous conditions for Scottish firms in developing products and software packages in particular.

The advantages of this strategy are:

• a matched response to the global nature of the software industry;
• better concentration of software products as the more profitable market offerings enabling higher growth within the industry.

It will address some specific weaknesses of the current performance of the sector namely:

• profitability appears to be low - typically 5%. This is in line with the high service orientation and small firm dominance of the sector in Scotland but does not bode well for future growth;
• although there are significant overseas sales by a handful of firms, Scotland’s export performance in software is generally poor; the majority of ‘exports’ being to the rest of the UK. Again, the service orientation of the sector is a root cause, as is the high proportion of software employees, in in-house departments who indirectly export software embedded/or adding value to hardware and electronics;
• software performance in Foreign Direct Investment has been poor being less than one in 20 projects and about 0.5% share of the investment and 1.7% of the jobs created.

As such, a strategy in which internationalisation and productisation are central themes offers an excellent way forward for the software community. Clearly, the strategy must also look to address other specific and longer term development issues such as increasing the software business birth rate, the shortage of both technical and business management skills, and better access to finance for deal making.

The vision of being a significant, high value adding, innovative, globally networked and internationally recognised software region can only be achieved through time. The key thrusts of a strategy to achieve this are:

• infrastructure: creating the necessary and sufficient conditions for the industry to realise the vision;
• internationalisation: fully engaging in the global scene;
• productisation: focusing more on products and less on services to create a higher value-added industry; and
• innovation: an innovative regional capability within an industry that demands innovation.

We illustrate these strategic themes in the figure below:

A logical order for these thrusts - rather than a pure sequence - leads to the development routemap below:

In the next section, we use this development map to set a way forward for the Scottish Software industry.

In the previous two sections we have described Scotland’s potential in software and reviewed the strategic options. In this section, we set out the way forward for Scotland in realising the vision of a significant, high value-adding, innovative, globally networked and internationally recognised software region.

As we have described in the previous section, the "do nothing" option would lead to a Scottish Industry with reduced growth due to its high service orientation with "local for local" provision. Alternatively, the immediate steps forward in realising the vision would be for the key stakeholders to:

• further refinement, scoping and assessment of the strategic options;
• the establishment of key priorities;
• definition of key tasks, roles and resources.

However, this process can be accelerated by the strategy presented in this document. We set out below a series of initiatives that can be fed into the steps set out above. These initiatives are not a "wish list" or an ad-hoc set of quick fixes. Rather, they represent a symbiotic and integrated approach that has been developed with the input and support of the Scottish Software industry. Whilst the ideas presented emerge from our analysis of the capability and forces affecting it, they have been further developed and refined by the industry itself.

We put forward the following programme of initiatives for discussion and further development by the partners and stakeholders in the Scottish Software Community. They need to agree more detailed architecture and design for many of the initiatives, their prioritisation and the resource implications together with industry specific programme champions.

The first major strategic thrust is intended to develop the Scottish software infrastructure. One key way of developing the infrastructure is to promote key projects that act as the focus for wider support enabling critical mass and creating major nodes in the industry’s structure.

The purpose of this initiative is to increase the Scottish and international profile of Scottish software by providing significant levels of public support to one or two specific projects that develop the Scottish industry in areas recognised as very high growth and high value. For example, it could involve support to projects to develop software for Internet applications or Electronic Commerce.

The initiative would comprise the identification of candidate key areas and the design of a programme of projects to respond to these consisting of research, product development, marketing, and capital investment. The programmes could attract interest from a wide range of Scottish software firms contributions from indigenous user firms and interest from foreign firms not currently engaged in Scottish industry.

The benefits would be twofold, first, Scotland would gain a technological and marketing advantage in a key software area. Second, the critical mass afforded by the high profile projects would attract substantial international interest, assist with the marketing of the technology, and help to provide international marketing channels. A model for this initiative could be the interactive TV trial in Cambridge. It involves co-operation of several local telecoms players but has attracted interest and investment from outside Cambridge.

High profile Scottish Software projects would compensate for the lack of international recognition and penetration across the portfolio of Scottish software firms.

The second key area of infrastructure requiring attention is that of skills. Clearly, software is highly demanding in terms of skills. Yet required skills infrastructure behind the strategy will be highly heterogeneous and not solely consisting of software engineering qualifications.

Indeed, there are three areas in which skills need to be better understood, developed and accessed:

1. The industry needs more ready access to individuals with direct commercial experience of growing software firms, and business support services with specialist knowledge of the needs of growing software firms. The mechanism required is to develop an intelligent facilitator who can interpret companies needs with mentors and specialist service providers (e.g. IPR, finance, innovation, marketing and distribution channels).
2. One interesting aspect of software as a business is that business formation within universities is much more frequently driven by the students than, for example senior staff, than is the case for other types of university spin-offs. This is due to the low capital requirements of starting a software business coupled with its technocratic (and frequently obsessional) nature.

3. The different levels and combinations of skills required in software is complex. A better, more detailed understanding of the Scottish labour market in software is required. This should establish the current position in terms of demand and supply of different skills, and likely future changes and challenges to both providers and users of skills.

Our fieldwork shows the dynamic nature of the Scottish software industry with continually evolving structure. To implement the strategy, key stakeholders must understand this infrastructure and record sensitivities to strategic actions. Unfortunately, for an evolving industry such as software, the Standard Industry Classifications are totally inadequate for this purpose. Indeed, for the purposes of strategy development we have developed from scratch the industry baseline data on size, make-up and growth.

Reconstructing this baseline at some future time will be expensive and inefficient. Yet it will be necessary for future strategic development. A case in point is business to business benchmarking when there is little understanding of which metrics matter. This is well illustrated by lack of understanding within the industry of acceptable and target levels of profitability.

Therefore, the aim of this initiative is to create a data collection process to provide strategic intelligence on industry performance to the software community and industry in Scotland.

The database of firms in Scottish Software constructed as part of this study would be the starting points. With this, key metrics would be collected on a consistent basis from the software community whereby its changing shape and strategic development would be understood.

Key metrics include:

• number of firms;
• number of employees;
• turnover;
• product/service profile;
• customer sectors.

Additionally desk research to benchmark Scotland against other competing and/or similar regions on a continuing basis should be explored.

One of the principal thrusts within this strategy is that Scotland should be much more fully engaged in international software activity. Software is increasingly international in nature.

A key element in further developing this international capability and addressing Scotland’s key infrastructural weakness - namely, the lack of major software companies - is inward investment.

Therefore, this initiative would focus on attracting major software development centres to Scotland.

Scotland has had considerable success in attracting FDI, particularly electronics and related assembly operations. Within this investment, there are four notable companies (whose business is not principally software) which have developed significant local (software) capabilities - NCR, IBM, Hewlett Packard and Motorola. This added capability is important and attractive to Scotland in that it develops local added-value and helps to sustain and anchor the manufacturing operations. There are also some local benefits to Scottish software industry through activities such as local sourcing of software development, although generally this is not well developed.

However, the addition of software activities (product development) to electronics hardware is more related to developing the hardware industry than the software industry.

From a software perspective the more significant gap is the lack of a major scale international software development company. There are mobile projects in software development where Scotland can compete. Early and first generation, international projects were concentrated on the downstream value chain including distribution, replication, customisation and subsequently customer service and support. During the last five years more high value projects in R&D have emerged given skill shortages in the country of origin of investors (the US). They are attracted by skill availability not low cost.

This will require a significant targeted effort - based around developing specific propositions to international software firms for example:

• where the project is not a trading entity which obviates corporate tax disadvantage versus Ireland and Netherlands - probably R&D;
• where local demand can be leveraged - as for example with financial services or utilities or shared services centres;
• where a compelling case for local skills availability and flexibility of course design can be developed with HEI;
• where a communications/access argument can be developed that supports the individual project.

The effort involved would be significant and within limited resources necessarily trade-off against other FDI activities. However, we believe the need for flagship activity is compelling as it would:

• directly assist in internationalising the Scottish industry structure;
• put Scotland more on "the international map" and position it as a serious contender for software development and indeed related design and development projects in hardware manufacture;
• provide an added facility for business formation;
• challenge and develop local software skills and training;
• possibly work on advanced products with local users;
• provide added business to local software firms through sourcing and joint development;
• possibly provide an additional channel to market.

To realise the internationalisation thrust with the strategy, Scottish firms must engage in product development with firms outside Scotland and the UK. Crucially, internationalisation is not just about trade, but rather about international interaction at every level of the product development lifecycle. Scotland’s key regional competitors (such as Israel) have achieved this.

Therefore, this initiative - which applies equally to the goals of internationalisation and productisation - would set up product development programmes with bilateral support and participation between Scotland and a targeted country or region.

The initiative would comprise assistance to firms wishing to undertake product development with organisations from other countries. It would specifically target US firms and could look to be involved in the early stages of platform development where participation in the formation of de-facto standards can provide first mover advantage. Existing SPUR and SMART awards address this area for research but not for products close to market.

This initiative would be particularly effective in developing technical linkages with US firms that may complement and help to develop market and commercial linkages. As an additional benefit, Scottish firms would obtain more accurate and more advanced market information on industry trends.

The idea for bilateral product development programmes stems from the successful BIRD programme in Israel during the late 1980s. The BIRD programme was successful because it developed both technical and marketing links with the US that have subsequently been exploited. In addition, it has generated substantial US interest in Israel and may have been a contributory factor in investment in the Israeli industry. Previous UK initiatives such as the Software Products Scheme in the late 1980s were also successful in this regard.

The initiative could be deepened and anchored through seeking a joint funding arrangement with another country or region where mutual benefits could be identified. For example, UK/European market access for N American products; N American market access for Scottish/UK products.

This initiative is responsive to two specific deficiencies in the current Scottish software industry structure, namely:

• concern for the low level of product development in Scots industry;
• remoteness in engagement in the development of international standards.

As far as take up of this initiative is concerned, we believe that significant effort and encouragement should be made to enable Scottish firms to be involved. On the other hand, if Scotland can establish a sufficiently high profile, US firms - that are highly proactive in looking for new sources of product ideas and, perhaps, lower cost sources of new product code writing - will be responsive to approaches from Scottish firms.

In addition to extending the international reach of Scotland’s product development, the industry must develop more sophisticated ways of dealing financially with firms in other countries over and above straightforward trade. Again, this initiative is vital to our thrust on internationalisation.

This initiative would promote linkages between Scottish software firms and the subjects of our exemplar studies; Israel and Colorado, led and implemented by the firms involved. Crucially, these linkages would be private sector to private sector with a view to setting up deals that might involve reciprocal market access, direct routes to the US market, and might include finance and equity exchange. Transactions of this nature are common in the global software industry but almost unknown in the Scottish case.

The initiative would comprise the identification of priority target regions and direct introductions between known firms in those regions with specific Scottish software companies. Our exemplar studies confirmed that there is strong interest in both Israel and Colorado. It is opportunistic, and leverages contacts developed and the research effort.

We believe that this initiative would be highly beneficial because market channels - especially those involving US firms - are the key to success and growth in the software industry. At present, only a handful of Scottish firms have a truly international presence and those that have high levels of exports do so through close, strategic relationships with US firms. Wider engagement in this form of activity would enable faster growth in the Scottish industry as a whole.

This initiative is especially pertinent to the Scottish case. The current lack of large firms within the Scottish software infrastructure means that use of large firms for market access - demonstrated as key in the exemplar studies - is not a local option for Scottish firms.

Whilst some promotion of this initiative would be necessary, our face to face interviews revealed that the logic of creating these commercial linkages is self evident to the majority of Scottish software firms; especially those in product development. This initiative would be particularly successful if the "quick win" could become part of Scottish software folklore, thereby attracting broader interest.

It is vital to make sure that Scotland retains and fully exploits its ability to develop software products if future growth is to be sustained. Scotland’s software product firms gravitate towards service provision as a low risk approach to growth. At the industry level, this reduces the overall value-added performance and profitability of Scotland’s software firms.

One key barrier to product development - clearly identified through our discussions with Scottish software firms - is that the local industry base (for any given firm) is relatively small, making it difficult to find appropriate test sites for software. This situation is further exacerbated by apparent unwillingness of local industry to participate as test sites even though this often entails economic benefit (ie free product use).

Therefore, this initiative would provide encouragement to organisations in any sector in Scotland that would participate in testing and proving Scottish software products; for example beta testing.

Obtaining a test site for a software product is an extremely important step in its development. There is currently a scarcity of appropriate and willing test sites within Scotland and this initiative would act to reduce this barrier. The credibility enjoyed by firms who have identified successful test sites provides a strong boost to marketing the product more broadly.

Give the vital importance of growing Scotland’s product development capability as a key strategic thrust it is notable that specialist expertise and experience is required develop software products, access appropriate finance, and work with channel partners and hardware suppliers requires. As with other proposed programmes, we see a requirement for a mechanism to make the connection between firms’ requirements in productisation and specialist skills.

The aim of this initiative would be to:

• provide a wider, more accessible pool of commercial skills with experience of the high technology/software sectors;
• create a forum to develop initiatives that address the changing needs of start-up software firms in Scotland.

These skills are rare and in significant demand in Scotland. The pool needs to be developed through the creation of a mentoring network. We believe the network could include individuals with direct experience from the US, and indeed from our exemplar regions. This would provide:

• better international linkages;
• access to a wider range of solutions;
• rapid knowledge and access to contacts.

There are various ways that networks could be established but clearly a bulletin-board and news feature within a web site (including Scottish firewall) might provide the most appropriate media.

Further support to the productisation thrust should be centred around Scotland’s ability to engage fully in international product development. This will enable Scottish firms to have the earliest possible involvement in emerging software platforms and technologies. For example, at present, web browsers, internet applications, open and pseudo open systems, organisational resource planning tools and trading on the internet are examples of key opportunities for software firms in Scotland.

Consequently, Scottish firms must enter into strategic alliances with (mainly) US firms. The drivers behind this are:

• US firms hold first mover advantage and, while JAVA and open systems are the growing area today, Scotland needs earlier insight into the emerging technologies and operating systems of the future;
• Product development cycle time and product lifetime in the market are getting shorter. In the future, Scottish firms will not be allowed the luxury of catching up once technologies such as JAVA become more commonplace. Strategic alliances can provide vital early market intelligence.

Therefore, this initiative - alongside initiatives 5 and 6 - looks to encourage Scottish firms to enter strategic alliances. For example, setting up alliances often requires additional experience and costs within the firm. More often leverage of the previous initiative (expertise and mentoring) could be the key.

The final thrust of the strategy is innovation: developing new ideas and technologies and converting them to generate wealth from the market place. Whilst the thrusts in internationalisation and productisation provide the market intelligence and commercial steer, any position gained by Scottish firms can only be sustained if their international partners perceive them as adding significant value in terms of innovation.

The keys to future innovation are largely cultural - a society that promotes and rewards invention and commercial exploitation - and local demand related - a ready market that rewards this corporate behaviour. We propose below, two initiatives to address these points.

The aim of this initiative is to expand knowledge and understanding of success strategies of innovative software firms. The war stories should be a mixture of local (Scottish) UK and companies from overseas.

This could be directly linked to the Mentoring Network - for example inviting CEOs and founders to work through their company’s development profile, including hurdles and solutions realised. Some initial research to identify company candidates and strategies would be necessary.

The audience would include:

• start-up firms;
• intermediaries (including financiers);
• students;
• business support/advice agencies.

We have identified four vertical industries that offer potential to access international markets and provide significant local innovative demand:

• Financial Services;
• Oil & Gas;
• Utilities;
• Information and Communications Technology.

This initiative would aim to identify innovative, advanced high level requirements of users, matching the requirements to the capabilities of individual Scottish software firms (or combinations of firms).

We do not foresee any direct subsidisation process, but by bridging an information gap and through raising customer awareness, commercial arrangements would flow.

Our vision for a Future State Scottish Software Community is that it is:

• internationally recognised;
• globally networked;
• biased toward Products and Innovation;
• high value adding; and
• of significant scale.

Long term (10+ years) the software community in Scotland should aspire to be in excess of 50,000+ professionals and be internationally credible.

We recommend that the major partners and stakeholders in the Scottish software community be involved in the translation of these broad strategic themes and programmes into a set of more specific concrete initiatives.

The executional capability of those delivering and facilitating the initiatives is the most important ingredient in their success, and the achievement of strategic change.

To facilitate this process, and to provide better institutional linkages and knowledge sharing we propose the establishment of a Knowledge Institute for Scottish Software (KISS). This could be a virtual organisation, developing strong networks and linkages both locally and internationally.

It could be nested in an existing institution (e.g. Scottish Business School) and provide the base for knowledge sharing. It would be a candidate to drive and link some of the proposed initiatives, for example those relating to networking, and the "access to expertise" component within skills.

In looking to implement the strategy, we recommend that the following issues are taken into account:

• this strategy highlights key trends that will put increased competitive pressure on Scottish Software. This threat is the basis of a powerful business case that drives the need for the strategy;
• the themes of internationalisation, productisation and innovation provide a clear focus for the way forward for Scotland;
• the strategy represents a significant but welcome change for the industry that requires "change leadership". This leadership can only come from the key players in the industry;
• implementation requires communication specific to the software community and should aim for the widest stakeholder commitment.

The immediate next step is for the key stakeholders to refine, scope and assess the initiatives in the light of the existing industry input to them. Then, once priorities are agreed, the stakeholder will define key tasks, roles and resources. The refined initiatives would then be put in place without delay.

We have set out a series of initiatives within the strategic themes; internationalisation, productisation and innovation. Each initiative supports these themes whilst addressing specific shortfalls in the Scottish software infrastructure.

The invitation to tender (January 1996 Version 1.1) defines those elements within the software supply chain that are to be included in the strategy, namely organisations which:

• Develop software products for sale to end-users.
• Develop systems software/tools for sale to end users or other vendors.
• Buy in and re-use software and add services selling solutions to end-users.
• Provide services relevant to the use of software by end-users.
• Develop software for incorporation in hardware solutions.
• Provide training services in the use of software products or the effective use of software by end-users.

Excluded from the scope as defined in the ITT are:

• Software development functions of in-house IT departments.
• Organisations which retail hardware only.
• Data processing bureau services.

We have added the software development functions of in-house IT departments to our definition of the software community. They represent an important seedbed for innovation and are professionally networked with the software industry.

Ernst & Young’s process for the development of a software strategy for Scotland was based on four cornerstones:

• the current state analysis provides a clear, informed view of the size and composition of the Scottish Software Sector;
• the global context provides an analysis of the global software market within which the Scottish Industry operates and the global industry trends that will affect it;
• the exemplars provide insights on the way that different regions or locales have worked to develop their software industry;
• the development issues that set out the key questions to which the strategy must respond.

The development of the national strategy required a clear and informed view of the size and composition of the Scottish Software sector. We also sought to understand the dynamics of the sector in terms of growth, performance and the links between organisations that form competitive industry groupings. All these factors are formally embodied in the current state analysis.

To characterise the economic profile of the Scottish Software Industry, we developed a database of firms in Scotland meeting the criteria as described in Appendix A. The database entry for each company included information on the size of the firm in terms of its turnover and employees, the location of the firm, its ownership status, and its classification of products and services (using the IDC classification also described in Appendix A).

In developing the database, we carried out the following tasks:

• entry of data collected from the SSF directory 1996 (for full members and associate members) into the database structure;
• the addition of SSF members on the 1995 directory in the case where these were not included in the 1996 listings and the firms were still trading;
• the classification of the firms included in the directory according to the IDC classification segmentation scheme (based on the descriptions in the directory and, where relevant, the interview programme);
• the identification of several web-sites representing firms in Scotland selling software. We contacted the firms directly to obtain data on revenue, employees, and activities;
• on entering the data, some considerable refinements were made. For example, many of the Directory entries for employees and turnovers corresponded to the UK as a whole, or indeed, Europe or Worldwide. In such cases we contacted the firms directly by telephone to request the relevant data for Scotland;
• contacting the larger firms in IT hardware, telecommunications and financial services concerning the existence of dedicated internal software development departments and the number of employees in these departments;
• contacting autonomous software divisions of the major corporations to ensure that our employee/turnover data is correct.

Having entered the data, we undertook a significant amount of data filtering as follows:

• we removed firms from the database that were: not software firms, not based in Scotland, and those that did not fall within the analysis scope described in Appendix A;
• in addition, we analysed all firms with a database entry for employees greater than 50. In these cases we checked the data by cross-referencing with the results of our interview programme, discussions with the SSF and, when still in doubt, made direct contact with the firm.

Subsequently, we made further modifications to the database as follows:

• the addition of some key Scottish hardware manufacturers; adding data for the embedded software component only;
• the addition of a more comprehensive range of financial service firms with significant internal software development activities;
• the removal of some firms from the database that, on review, were not regarded as truly software firms;
• the downward revision of some of the figures for the number of employees for the larger firms in the case where a significant proportion of staff are not directly involved in software;
• performing sanity checks on the data such as analysing revenue/employee ratios and examining data outliers.

For the most part, the data analysis drawn from our current state analysis reflects precisely the information available in the database. As such, we propose that the database is representative of the industry covering, we estimate, upwards of 80% of relevant activity.

There are gaps in the data in the case where firms were not willing to disclose the relevant information. For example, only about one in five firms has revealed information on turnover. Since many of the firms are private independents, this data is not readily available. Therefore, for some of the data we have calculated gross estimates based on the data set as a whole. This applies to the total turnover from the industry, and the number of firms.

To provide a gross estimate of the total turnover of the Scottish Software industry, we calculated the total turnover from those firms1 for which we could obtain both turnover and employee data. A total of 61 firms provided data on both turnover and employees. These firms were predominantly independent software firms. Collectively, these firms had a total of 4,378 employees developing £305.9 million of sales per year. This leads to a sales figure per employee of £69,878. The median sales per employee across the dataset is £60,000 with lower and upper quartiles of £45,000 and £100,000. We then benchmarked these data against internal Ernst & Young knowledge, finding the figures to be reasonable. Therefore we took the mean sales per employee figure of £69,878 as the basis of our industry turnover estimate. Given the significance of in-house software development activities of large firms, industry turnover includes final costs to customers, as a proxy measure of internal transactions.

Given these figures and our estimate that the Scottish industry has about 19,600 employees, we then calculated a gross estimate for the revenue from the Scottish Software industry as £1.4bn per year.

To generate a comprehensive set of development issues, we interviewed individual organisations within the software industry in Scotland: including 35 firms and 25 related organisations (listed in Appendix H). We consulted these organisations to gain insight into their corporate profile and the way in which the firms were formed and developed. We discussed with these firms the products and services that they provide, how they place themselves with respect to competitors and the future strategies they wish to adopt. We included within our consultations, the firms that are well established in Scotland as well as newly established firms. We consulted with dynamic firms within the Scottish industry whose stories have become folklore within the sector, as well as software firms that ply a steady trade with no ambition for dramatic growth.

In doing so, we have documented the opportunities within the software sector as perceived by Scottish firms. Those firms also experience significant constraints to their development and our survey has enabled us to capture and synthesise these points. Crucially, since the fieldwork was undertaken at the same time as our desk research on the global context, the consultations with firms highlighted disparities between the position and strategic direction of many Scottish Software firms and important global trends that will shape the industry in years to come. As such, the consultations raised a number of the development issues that need to be addressed by the strategy.

Our three areas of focus were:

The software industry in Scotland (firms whose principal business is software) has grown to become a significant sector with employment at about 19,600 and output at about £1.4 billion pa. In employment terms, software is now more important to Scotland as whisky.

Scottish software firms are predominantly either very small - with one or two employees - or within a significant size range of 11 to 50 employees.

However, there appears to be little cohesion between these firms although prominent geographical concentrations can be associated with certain vertical markets such as Finance (Edinburgh) and Oil and Gas (Aberdeen).

Most Scottish software firms are independent with local decision autonomy.

The Scottish industry exhibits bias towards services rather than product offerings. Service offerings are most commonly at the planning and implementation end of the spectrum. Product offerings are focused on applications; mostly industry applications although with a balance across vertical and horizontal industry applications. However, as with many other regions Scottish firms producing applications cannot rely on indigenous suppliers of application development tools or operating systems.

In terms of educational capability, Scotland produced 688 first degree graduates in computer science in the academic year 1995/96. The total number of first degrees awarded in this subject and the other science and engineering fields was 23,064. As a proportion of total graduate output, Computer Sciences is slightly less well represented in Scotland than in the UK as a whole. However, Scotland produces a much higher proportion of graduates in Engineering and Technology.

It is important to note that software professionals have a wide variety of degree backgrounds; often coming from non technical disciplines. In addition, we make no judgement as to the quality and commercial suitability of the courses taught in Scotland. Graduate output figures are, therefore, a poor indicator of the level of software skills available. Indeed, many software engineers do not hold degrees.

Over the last five years the Scottish software industry has exhibited significant growth in employment and revenue. In the short term, expected growth of the European market and the firm expectations of substantial players suggest that growth may be sustained. Additionally, demand will be underpinned by the significant effort required in addressing the ‘Year 2000’ issues, and in managing the transition to the single currency. If growth is sustained for a further five to six years, software activity in Scotland will double in size. Therefore, a key feature of the strategy is how Scotland can best nurture this growth and develop a stronger, more international industry.

Whilst Scottish software exhibits significant growth, certain aspects of the industry have been disappointing:

• Given the global nature of the marketplace, few Scottish firms export beyond the UK.
• Inward investment has been low although projects have produced new jobs at much higher levels per pound than other investments.
• Whilst data is scarce, we suspect that software conforms to the Scottish trend for low rates of business birth.

Scottish software offers critical mass in certain vertical markets such as finance, oil and gas, and utilities. However, the typical characteristics of industry clusters - such as cultural drivers, staff interchange, and generation of spin-offs - do not appear to be in evidence. Indeed, at present these vertical industry groupings show little coherence or characteristics of mature clusters.

In analysing the global context for the Software Industry. We synthesised the most up-to-date data relating to the Software Industry worldwide and highlighted industry, user, and technology trends that are shaping the development of the industry. As such, we were able to highlight some strategic issues for the industry as a whole.

In this appendix, we review each of the issues raised in the global context report taking a view - based on our industry consultations - as to the comparative position of Scotland based on our consultations.

Our analysis of the global context confirmed that world markets for software & services are expanding rapidly. The European market is expected to grow at the same pace as the global market whilst the UK itself is expected to grow at a faster rate than the European average. We were not able to ascertain Scottish-specific data on markets but the current state analysis indicated that Scottish output has grown considerably over the last 10 years.

Our analysis showed that, in terms of exploiting world markets, US firms dominate. They are prominent in the UK package software market and also have the largest share of the UK services market. During our consultations with Scottish software firms we gathered data on the perceptions of firms of their markets in terms of the geographic location of competitors. We also questioned firms on the geographic profile of their sales.

Interviews with firms in the "growing/established" category showed that some of these firms were proactive in seeking wider geographic markets for their products and are exploiting key market channels into the US. However, in synthesising the responses across the majority of firms, a parochial view of markets is most common. Indeed, use of market channels into the US is the exception rather than the rule.

A well-established practice within the industry that computer hardware firms look to ensure that there is software available for their products when they go to market. PC and workstation software is developed mainly by independent firms and designed for specific microprocessor architectures. However, this first mover advantage largely remains the preserve of US software firms. During our consultations, we did not find a single case of co-operation of hardware firms and independent software firms; although we acknowledge that Scotland has significant software capability within Hewlett Packard, NCR, and IBM that is clearly closely linked to hardware. We must surmise that Scottish software firms - in common with their counterparts in Europe as a whole - continue to have a significant competitive disadvantage compared to US firms; especially in the case of operating software.

Our analysis of industry trends shows that PC and workstation manufacturers are increasingly forming alliances with independent software vendors to ensure software systems compatible with their products. Again, Scotland - like the rest of Europe - may be lagging in this respect because our consultations did not reveal any alliances between Scottish Independent Software firms and US hardware manufacturers.

Packaged software is tradeable and therefore more easily exportable whereas custom software development is a service and, thereby, more limited to domestic or local markets.

The world packaged software market is massive - currently estimated at $102 billion. The European market for applications packages is expected to grow at 10% cagr to the year 1999. Therefore, software firms in relatively small domestic markets - as in the Scottish case - may look to grow internationally by standardising and packaging their software solutions.

However, our consultations in conjunction with the current state analysis show there are considerable disparities between this logical market progression and the position of Scottish Software. In Scotland, about 40% of firms provide both products and services and it is difficult to disaggregate the balance between products and services in the sector. However, if we examine the number of firms that provide products only, or services - only, the bias is strongly towards services and away from products. In addition, the current state analysis showed that whilst there are significant overseas sales by some firms, the majority of exports from Scotland are to the UK.

This picture is compounded by the intelligence gathered during the consultations that showed, first, that very few firms are looking to "shrink wrap" their products (that is, create standalone applications solutions that require little support post purchase) as a means of increasing exports and profitability, and second, that Scottish firms are constrained in "productisation" by lack of both technical and commercial skills.

The key global trend raised in our research is that use of open systems could lead to a redistribution in the balance of market power from software giants to smaller firms and new entrants. In some respects, this should be beneficial to the Scottish case because, as we showed in current state analysis, the Scottish Industry is dominated by small and embryonic firms. We expect that web browsers (the interface between the Internet and the user) will gain importance compared to operating systems or hardware platforms. The question is whether small, innovative firms will be able to enter the new markets for JAVA tools and applications and provide Internet services. It certainly appears that there are significant market opportunities for developing new products using JAVA applets and offering services related to the Internet.

Our consultations showed that Scottish Software firms were generally well aware of the technological developments of the Internet. However, very few firms were looking to exploit this opportunity. This is an important disparity between global trends and the Scottish position.

In addition, one of the key features of trade on the Internet is that origin of the services is not immediately obvious to potential customers whereby size of firm, and its structure do not constitute obvious commercial barriers. Therefore, small and mid-size firms should be more easily able to market services & products internationally. We expect this to be especially important in the software industry where US firms have traditionally had more creditability than European counterparts.

Again, opportunities exist for Scottish firms to emulate their US counterparts by providing products and services over the Internet. During our consultations, we asked Scottish Software firms what they viewed the Internet as offering their businesses. The vast majority of Scottish firms were sceptical about the possible opportunities. Some firms had invested in setting up web-sites but had not found them to be particularly useful in generating new business. Whilst we must accept these commercial judgements, it is interesting to note that most Scottish firms are prone to question the conventional wisdom within the industry.

The trends towards open "open-systems" is making operating systems the critical interface between application software and a variety of hardware. This is reducing the importance of the hardware components as the key system-determinant. The two issues arising from this are, first, the partnership between major operating system developers and hardware firms are becoming increasingly important, and second, that standards-forming alliances may have a strong role to play in the future.

Earlier in this section we noted the lack of links between software firms in Scotland and hardware producers. So the first issue to reiterate is that neither major computer hardware producers or operating systems producers carryout significant levels of product development in Scotland. However, the second point adds an additional issue, in that our consultations reveal that Scottish firms have very little involvement in the standards forming alliances that will set the de-facto alliances of the future.

Both of these issues represent a major disadvantages for the Scottish industry which should be addressed in developing the strategy.

The impact of shorter product lifecycles in the software industry is likely to be a relative increase in development costs.

This trend acts to reinforce some of the key issues raised above - namely:

• custom software producers will increasingly come under pressure to package their products;
• the need to forge closer relationships with hardware manufacturers to gain first mover advantage;
• the need to increase alliances within the industry to reduce overall product development costs;
• the need to internationalise products quickly to amortise developments costs and maximise margins in the growth stage.

Whilst several Scottish Software firms are cognisant of these needs, very few firms emphasise these points when responding to questions concerning their vision for the future of their business.

To conclude this appendix, we note that reading across between the results of our global context analysis and the output from our consultations has raised important disparities between the Scottish situation and global trends.

In the light of the results of our consultations with Scottish firms significantly involved in software developments, we believe that there are two related priority issues for the National Software Strategy for Scotland. We have selected these two on the basis of the inescapable messages from the Global Context analysis (and to an extent the exemplars). They are:

• first, that Scottish software firms in general must increase their internationalisation - and embryonic firms must internationalise earlier in their development cycle; and
• second, that Scottish firms must productise as far as possible.

Since both of these "musts" place strong demands on firms, there is a clear role for the strategy in addressing them. We summarise the drivers behind these issues in the charts below.

Additional development issues raised in the context of underpinning growth and development included:

• software business birthrate is increased;
• Scottish firms adopt more challenging visions for growth;
• the experience of non-executive officers is brought to bear on the key corporate questions of productisation, internationalisation - and a wider geographical scope of capital is accessed to invest in these developments;
• Scottish firms can access the necessary commercial and technical skills.

We summarise the drivers behind these issues in the diagrams below:

In developing the national software strategy for Scotland we held a strategy workshop in Edinburgh involving:

• Indigenous software companies;
• Software users;
• Foreign owned software companies;
• Academics;
• Public sector agencies.

The purpose of the workshop was to help develop solutions and ideas to agreed development issues.

All attendees were issued with a briefing pack summarising:

• The Approach;
• Global Context;
• Current State Analysis;
• Exemplars.

The workshop process was focused around brief introductory exercises followed by break-out groups each focused on particular issues. Results from the break-out groups were presented to the planning sessions of all attendees and captured on a "Power Board"

The summary results of the workshop were:

• to confirm the key development issues and barriers facing firms in Scotland;
• to create possible solutions and ideas to address to some of the development issues and barriers.

In generating our final list of strategic initiatives we considered the solutions generated in the workshop, and also subsequently discussed these with selective participants.

We are grateful for the co-operation of those who attended and contributed to the workshop.

We undertook several studies of other geographic settings of software industries to contribute to our development of the national software strategy for Scotland.

The segmentation of the exemplars was as follows: